Guidance from Bank Regulators on Managing Commercial Real Estate Concentrations

Transcription

1 GLOBAL BANKING & MARKETS Guidance from Bank Regulators on Managing Commercial Real Estate Concentrations Richard Daingerfield Chief Legal Officer, The Royal Bank of Scotland plc NY Branch Chair, Banking Law Committee s Commercial and Real Estate Lending Subcommittee ABA Business Law Section Meeting, Dallas, TX, April 2008

2 Topic Managing Commercial Real Estate Concentrations In December 2006, the federal banking regulators (Fed, OCC, FDIC and OTS) issued guidance to all banks on managing commercial real estate risk. Why did the regulators issue it? What does it say? Fast forward to today. What s up in the commercial real estate market? What s going on in banks? March 17, 2008 letter from FDIC to all banks. 2

3 Why did the regulators issue it? Trend in CRE Concentrations by Asset Size All Commercial & Savings Banks (Total CRE Loans / Total Risk-based Capital) Total Assets < $100 Mn Total Assets $100 Mn - $1 Bn Total Assets $1 - $10 Bn Total Assets > $10 Bn Percent Q3 3

4 Why did the regulators issue it? Risk management practices and strategic and capital planning have not always kept pace with growth in commercial real estate lending. FDIC bank examiners have reported: Some banks have not established exposure limits by type of property or geographic market. Some banks do inadequate interest rate stress testing, others don t stress test at all. Some banks fail to provide senior management with timely or sufficient information to enable informed decisions about real estate concentration risks. These were among the deficiencies that FDIC bank examiners found to be common: Source: From the Examiner s Desk... Examiners Report on Commercial Real Estate Underwriting Practices, Volume 3, Issue 2 of the FDIC s Supervisory Insights publication. Failure to track exceptions to the banks own policies. Failure to track the total amount of loans exceeding loan-to-value limits. Originating numerous loans in excess of loan-to-value limits without documenting credit factors supporting such underwriting decisions. 4

5 Why did the regulators issue it? Deficiencies were found despite longstanding guidance that requires banks to have written real estate lending policies that establish: Diversification standards. Prudent underwriting standards, including loan-to-value limits. Loan administration procedures. Requirements to monitor policy compliance; and Requirements to monitor market conditions. Source: From the Examiner s Desk... Examiners Report on Commercial Real Estate Underwriting Practices, Volume 3, Issue 2 of the FDIC s Supervisory Insights publication. 5

6 What do the regulators say that it says? Not really new: The 2006 guidance reinforces and builds upon the... existing regulations and guidelines for real estate lending and loan portfolio management. Not intended to slow or stop lending: The Agencies also have clarified that they are not establishing a limit on the amount of commercial real estate lending that an institution may conduct. Just intended to ensure sound management: Quotes are from the Supplementary Information published with the guidance. See 71 FR (Dec 12, 2006). The guidance... emphasiz[es] those risk management practices that will enable an institution to pursue commercial real estate lending in a safe and sound manner. 6

7 What does it say? Establishes numerical criteria for identifying banks with potentially significant commercial real estate concentration risk. Using Call Report data, supervisors will focus on banks with: Construction & land development loans 100% of the bank s capital; or Total commercial real estate loans (all types, in the aggregate) 300% of the bank s capital and 50% growth in that portfolio over last 36 months. 7

8 What does it say? Focuses on: Non-owner occupied loans where repayment is dependent on the rental income or sale or refinancing of the mortgaged real estate. Residential and commercial construction and development loans. Excludes owner-occupied real estate loans where repayment is from cash flow from operations. Excludes real estate taken as a secondary source of repayment or in an abundance of caution. 8

9 What does it say? A bank s risk management framework should include these key elements: Board and management oversight. Portfolio management. Management information systems. Market analysis. Credit underwriting standards. Portfolio stress testing and sensitivity analysis. Credit risk review. 9

10 What does it say? Board and management oversight. Have an overall strategy regarding the level and nature of commercial real estate exposures. Monitor to ensure adherence to policy. Monitor market conditions. Adjust policies to address changes in the market. 10

11 What does it say? Portfolio Management. Beyond managing individual loans, identify and manage the risks in the commercial real estate portfolio as a whole. Concentration in loans of the same type. Concentration in loans that are similarly affected by cyclical changes in the market. Establish concentration limits. Establish contingency plans to reduce concentrations in the event of adverse market developments (eg, securitize, sell whole loans or participations, etc.). Regularly review the robustness of contingency plans against changes in the market. 11

12 What does it say? Management Information Systems. Degree of sophistication will vary depending on size and complexity of commercial real estate portfolio and extent of concentration risk. Banks are encouraged to stratify portfolio by: Property type, Geographic market, Tenant concentration, Tenant industries, Developer concentration, Risk rating, Loan purpose (eg, construction, short term, permanent), Loan-to-value limits, Debt service coverage ratios, and Policy exceptions. 12

13 What does it say? Market Analysis. Board and senior management should receive information sufficient to assess whether strategy and policies remain robust given changes in market conditions. Perform periodic market analyses for the various property types and geographic markets in the portfolio. Particularly important when considering new markets and new loan types. 13

14 What does it say? Credit Underwriting Standards. Board and senior management should set: Risk limit levels it deems acceptable. Clear and measurable underwriting standards, including: Maximum loan amount by type of property, Loan terms, Pricing structures, Collateral valuation, Loan-to-value limits by property type, Requirements for feasibility studies, Sensitivity analysis or stress testing, Minimum requirements for equity investment by borrowers, and Minimum standards for borrower net worth, property cash flow and debt service coverage for the property. Periodic reports to board and senior management, including on exceptions to policy. 14

15 Commercial Real Estate Market Update Fast forward to today. Waiting for Armageddon Capitalism without bankruptcy... is like Christianity without hell. With recession looming, the air in America s bankruptcy courts is thick with brimstone and the coals are being heated in readiness for the many sad souls whose sin was to borrow too much. The Economist, March 29, 2008, p81. 15

16 Commercial Real Estate Market Update Korpacz Real Estate Investor Survey First Quarter 2008 National Highlights: Rough Road Ahead for Investors Everywhere investors turn, bleak news reports broadcast the message that the problems that spurred the housing downturn and subsequent credit crunch have unfortunately overflowed into the commercial real estate industry. Mortgage losses are up. Absorption levels are down. Consumer debt levels are up. Same store retail sales growth is down. Foreclosure rates have soared, and financial write-downs appear far from over. With some analysts predicting commercial real estate values to drastically fall in 2008 forecasting declines of 20% or higher, many investors are crossing their fingers and hoping that fundamentals stay sound and the economy rebounds sooner rather than later. Buckle up; we could be in for a bumpy ride. Published March 14,

17 Fresh Guidance from FDIC FDIC Financial Institutions Letter FIL March 17, 2008 Managing Commercial Real Estate Concentrations in a Challenging Environment Recent weakness in the housing and the construction and development (C&D) markets have increased the FDIC s overall concern for... concentrations in commercial real estate loans, and in particular, C&D loans. The purpose of this [letter] is to re-emphasize the importance of strong capital and loan loss allowance levels, robust credit risk-management practices, and to recommend several key risk-management processes to help institutions manage CRE loan concentrations in this challenging environment. The FDIC suggests five things to help banks with significant C&D and CRE concentrations manage through changes in market conditions. 17

18 Fresh Guidance from FDIC FDIC Financial Institutions Letter FIL March 17, Increase or maintain strong capital levels. It is strongly recommended that, as market conditions warrant, institutions with CRE concentrations (particularly in C&D lending) should increase capital.... Capital protection for C&D and CRE concentrations should be a strategic priority when contemplating the declaration of cash dividends. 18

19 Fresh Guidance from FDIC FDIC Financial Institutions Letter FIL March 17, Ensure that loan loss reserves are appropriately strong. At least quarterly, institutions should analyze the collectability of CRE and all other exposures and maintain [reserves] appropriate to cover estimated credit losses on individually evaluated loans... as well as estimated credit losses in the remainder of the loan portfolio. 3. Manage construction & development and commercial real estate loan portfolios closely. Institutions should also effectively manage interest reserve and loan extension accommodations, reflecting the borrower s condition accurately in loan ratings and documented reviews. 19

20 Fresh Guidance from FDIC FDIC Financial Institutions Letter FIL March 17, Maintain updated financial and analytical information. [M]aintain recent borrower financial statements, including property cash flow statements, rent rolls... and other performance information. Consider the continued relevance of appraisals performed during high growth periods Bolster the loan workout infrastructure. Institutions should ensure they have sufficient staff and appropriate skills also effectively manage interest reserve and loan extension accommodations, reflecting the borrower s condition accurately in loan ratings and documented reviews. 20

21 For Further Information Longstanding Guidance: Fed: 12 CFR 250, et seq. FDIC: 12 CFR 365 Appendix A. OCC: 12 CFR 34.1, et seq. OTS: 12 CFR , et seq. December 2006: Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices. Fed, FDIC & OCC: 71 Federal Register OTS: 71 Federal Register March 2008: FDIC Financial Institution Letter FIL : Managing Commercial Real Estate Concentrations in a Challenging Environment. 21